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The Warren Buffet Way – Robert G. Hagstrom
June 12, 2007, 9:40 am
Filed under: investments/finance/economics

Notes taken from The Warren Buffet Way by Robert G. Hagstrom

Investing principles (Bill Miller’s foreward):

  • Think of buying stocks as buying fractional interests in whole businesses
  • Construct a focused low-turnover portfolio
  • Invest in only what you can understand and analyse
  • Demand a margin of safety between the purchase price and the company’s long-term value

Buffet’s personal qualities (according to Peter Lynch):

  • He is very content – he loves everything he does.
  • As an investor, he has discipline, patience, flexibility, courage, confidenc and decisiveness.
  • He is always searching for investments where risk is eliminated or minimized. In addition, he is every adept at probability and as an oddsmaker.
  • He lists his failures and mistakes and does not apologize.
  • He enjoys kidding himself and compliments his associates in objective terms.
  • He is a great student of business and a wonderful listener, and is able to determine key elements of a company or a complex issue with high speed and precisions.

From the 1996 Bershire Annual Report:

  • “Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now. Over time, you will find only a few companies that meet those standards- so when you see one that qualifies, you should buy a meaningful amount of stock.”

Kenneth L. Fisher on Buffet:

  • “…he always know exactly who he is and what he is about. He isn’t tormented by conflicts of interest that can undermine his principles and lead to less-than-admirable behaviors. There was no mud to throw so no mud stuck. And that is the prime part of Warren Buffet you should try to emulate. Know who you are.”

Intellectual influences on Buffet:

  • Benjamin Graham – “margin of safety” and quantitative evaluation of businesses.
  • Philip Fisher – “scuttlebutt” and qualitative evaluation of businesses.
  • John Burr Williams – the dividend discount model
  • Charles Munger – paying more for quality companies, intellectual perspective, “the big ideas” from all areas of knowledge, “latticework of mental models” for investors

The Early Days of Berkshire Hathaway

  • GEICO was an excellent investment vehicle: policyholders provided a constant stream of cash.
  • Buffett differentiated Berkshire’s insurance companies through two ways:
    • Financial strength
    • Underwriting philosophy: always write large volumes of insurance, but only at prices that makes sense.

Buying a Business

  • Buffett looks for companies he understands, with consistent earnings history and favourable long-term prospects, showing good return on equity with little debt, that are operated by honest and competent people, and, importantly, are available at attractive prices.
  • Buffett’s purchase of Scott & Fetzer Company – a company that creates a large ROE with very little debt.
  • Clayton Homes – Buffett made the decision to purchase it solely from his reading of the founder’s book, his evaluation of Kevin, the founder’s son, the public financials of Clayton and what he learnt from purchasing Oakwood Junk bonds that defaulted soon after.
  • McLane Company – an efficient, well-runned company built on strong principles and showing consistent profitability.
  • Buffett avoids commodity businesses and mangers that he has little confidence in.
  • Buffett’s most important stock holdings: Coca-Cola, Gillette, The Washington Post Company, Wells Fargo & Company.
    • Coca-Cola: example of a great franchise
    • Gillette: Buffett bought convertible securities when the company was in deep trouble with a negative net worth.
    • The Washington Post Company: Buffett was actively involved in influencing the running of the business

The Warren Buffett Way

  • Business Tenets
    • Is the business simple and understandable?
    • Does the business have a consistent operating history?
    • Does the business have favourable long-term prospects?
  • Management Tenets
    • Is management rational?
    • Is management candid with its shareholders?
    • Does management resist the institutional imperative?
  • Financial Tenets
    • What is the return on equity?
    • What are the company’s owner’s earnings?
    • What are the profit margins?
    • Has the company created at least one dollar of market value for every dollar retained?
  • Value Tenets
    • What is the value of the company?
    • Can it be purchased at a significant discount to its value?

Business Tenets

  • Simple and understandable businesses – know what you don’t know and apply what you know, “circle of competence”
  • Consistency
    • profitable and successful over the long term.
    • avoid companies that are fundamentally changing directions
    • “severe change and exceptional return usually don’t mix”
    • avoid businesses that are solving difficult problems
  • Favourable long-term prospects
    • Buffett feels the economic world is divided into small group of franchises and a much larger group of commodity businesses.
    • He defines a franchise as a business whose product or service (1) is needed or desired, (2) has no close substitute and (3) is not regulated.
    • the key to investing is determining the competitive advantage of any given company and above all, the durability of that advantage.
    • Franchises can regularly increase prices without fear of losing market share or unit volume, hence earning above-average returns on invested capital.
    • Franchises possess a greater amount of economic goodwill, which enables them to better withstand the effects of inflation.
    • Franchises are better able to survive economic mishaps and still endure.

Management Tenets

  • Seek management that think like owners, possess great integrity and resists the “institutional imperative”- the tendency to blindly follow peers.
  • Rational managers are important: capital allocation in terms of how earnings are reinvested or returned to shareholders determines shareholder value in the end.
  • If extra cash can be reinvested internally at a return of equity that is higher than the cost of capital, management should retain all earnings.
  • A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) it can ignore the problems, (2) it can buy growth, or (3) it can return money to shareholders. It is here where Buffett focuses keenly on management’s ability to be rational.
  • Generally, management who continue to reinvest despite below-average returns do so in the belief that the situation is temporary. They are convinced that with managerial prowess, they can improve their company’s profitability.
  • If a company ignores this problem, cash will become an increasingly idle resource and the stock price will decline. A company with poor economic returns, a lot of cash, and a low stock price will attract corporate raiders.
  • To protect themselves, management often purchase growth through acquisitions.
  • Acquisitions are usually overpriced and provides no synergistic purpose.
  • To Buffett, management with a growing pile of cash should either return the money to shareholders in terms of dividends or buying back shares.
  • Buffett feels the reward is two-fold when management buys back stock.
    • If the stock is selling below intrinsic value, it makes good business sense, since the average investor would do the same too. Shareholders get more value per dollar from the purchase.
    • When executives buy back company shares, they are demonstrating that they have the company’s best interests at heart, which sends good signals to market and attracts other investors.
  • The institutional imperative
    • Some organisations resists change.
    • Some managers imitate peers.
    • Most managers cannot control their lust for activity
    • Most managers constantly compare the sales, earnings, and executive compensation of their business with other companies in and beyond their industries.
    • Most managers have an exaggerated sense of their own capabilities
  • Compare the claims of the managers in previous annual reports with the actual performance of the company in later annual reports.
  • Beware of companies displaying weak accounting; in particular, look out for companies that do no expense stock options.
  • Another red flag: unintelligible footnotes.
  • Be suspicious of companies trumpeting earnings projections and growth expectations.

Financial Tenets

  • Buffett doesn’t take yearly results too seriously. He focuses on four to five year averages.
  • Focus on return on equity, not earnings per share.
    • Since company retains earnings to increase their equity base, earnings per share is a smokescreen.
    • The test of economic performance is whether a company can achieve a high earnings rate on equity capital, i.e. ROE.
    • To use ROE, some adjustments must be made
      • All marketeable securities should be valued at cost and not at market value. Fluctuations in share price understates or overstates ROE.
      • Control the effects that unusual items may have on the numerator of ROE. Exclude all capital gains and losses as well as any extraordinary items. Isolate the specific annual performance.
  • Calculate “owner earnings” to get a true reflection of value.
    • Not all earnings are created equal.
    • Cash flow leaves out the important factor of capital expenditures
    • Buffett uses “owner earnings – a company’s net income plus depreciation, depletion, and amortization, less the amount of capital expenditure and any additional working capital that might be needed.
  • Look for companies with high profit margins.
  • For every dollar retained, has the company created at least a dollar of market value?
  • Buffett believes in good ROE with little or no debt – more debt exposes the company to economic slowdowns and risks.

Candor

  • Have the courage to discuss failure
  • Management should be able to discuss mistakes openly
  • Most annual reports are excessively optimistic and are shams.
  • There is value in studying one’s mistakes, instead of concentrating only on success.

Value Tenets

  • Determine the value of a business and buy only when the price is right – when the business is selling at a significant discount to its value.
  • Buffett uses the dividend discount model
    • The value of a business is the total of the net cash flows (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate, which is the risk-free interest rate, usually government treasury bonds.
  • Buffett looks for predictability of future earnings- a company with consistent earnings power and a simple business would be more predictable.

Focus Investing

  • Concentrate your investments in outstanding companies run by strong management.
  • Limit yourself to the number of companies you can truly understand. Ten to twenty is good, more than twenty is asking for trouble.
  • Pick the very best of your good companies, and put the bulk of your investments there.
  • Think long-term: five to ten years, minimum.
  • Volatility happens. Carry on.
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1 Comment so far
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Thank you. Very useful

Comment by rhain




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